Spruce Point Capital Management Announces Investment Opinion: Releases Report and Strong Sell Research Opinion on Xylem Inc. (NYSE: XYL)
Spruce Point Capital Management, LLC ("Spruce Point" or "we" or "us"), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled "A Leak In The Bull Case" that outlines why we believe shares of Xylem Inc. (NYSE: XYL) ("Xylem" or the "Company") face up to 30% to 45% long-term downside risk, or $58.00 ? $74.00 per share. Download or view the report by visiting www.SprucePointCap.com and follow us on Twitter @SprucePointCap for additional information and exclusive updates.
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Spruce Point Report Overview
Xylem is a designer, manufacturer and service provider for the water and wastewater industry that is a constituent of the S&P 500. Based in Washington, D.C., the Company was formed through the 2011 spin-off of the water-related businesses of ITT Corp. Today, the Company is organized into four segments: Water Infrastructure, Applied Water, Measurement & Control Solutions, and Integrated Solutions & Services. In May 2023, Xylem completed the $7.5 billion acquisition of Evoqua Water Technologies ("Evoqua") in an all-stock transaction. As of December 31, 2022, the combined Company had approximately $7.3 billion and $1.2 billion of revenue and Adjusted EBITDA, respectively, with approximately 54% of revenue in the United States and the rest globally. We believe both Xylem and Evoqua were under pressure prior to the transaction and that, going forward, the combined Company will fail to meet the aggressive growth expectations it set out during the acquisition.
The concerns we outline in our report include:
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We have found evidence that, prior to the acquisition of Evoqua, Xylem was struggling to meet its long-term goals as pressures were increasing. Spruce Point believes that Xylem's acquisition of Evoqua is an implicit acknowledgment of failure toward its 2025 long-term goals, which it previously outlined at its Investor Day on September 30, 2021. We believe that at least five of its financial goals (accretive M&A, digital growth, emerging markets, margin expansion, and free cash flow conversion) were on track for disappointment prior to the acquisition of Evoqua. In addition, Xylem talks about its potential with Advanced Metering Solutions, but we believe that, in the future, the market will shift toward smaller utilities where Xylem's solutions are less adapted. Based on our analysis, we have identified that Xylem exhibits a consistent pattern of delivering greater restructuring charges and less capital spending than forecasted. We believe such chronic underinvestment and frequent restructuring could reflect Xylem's inability to get an adequate return on budgeted capital investment and rationalize its complex organization. Moreover, we find that Xylem recently spent over $2 billion to acquire Pure Technologies and Sensus to drive its smart metering solutions in its Measurement & Control Solutions. However, despite claims that this segment can scale and that its digital backlog has higher margins, our research indicates that Xylem has struggled with technology integration and that Pure Technologies went from positive EBITDA to generating losses. Despite these circumstances, it appears that Xylem has sidestepped full impairment of the Pure acquisition's goodwill. Leading up to the acquisition of Evoqua, we find evidence that Xylem was experiencing greater financial strain. Notably, orders had declined sequentially for five quarters, with days inventory outstanding having reached a record high in Q1 2023. Like Xylem, we find that Evoqua's days inventory outstanding recently increased to an all-time high. Furthermore, in its final Annual Report prior to the acquisition, Evoqua added warnings about its ability to offset increased costs through pricing and modified statements about its product capabilities.
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We believe Xylem's liquidity is strained and there is no near-term path to accretive value creation. Based on interviews with two former Xylem executives who had a view into executive management and the Company's Board, we heard opinions that the ~22x 2023E EBITDA paid for Evoqua was "crazy expensive" and "surprising." One former executive believed shareholders should be disappointed that only $140 million of cost synergies are forecasted when $200 million is necessary to make the deal work. In fact, Spruce Point takes even further issue with the cost synergies initially presented by Xylem because they failed to adequately disclose that nearly $90 million of costs would be necessary to achieve the targeted synergies. Moreover, while Xylem is not quantifying any revenue synergies from the deal, some analysts are modeling them to justify more than 25% upside potential to Xylem's share price. During our interviews, one former executive commented about revenue synergies to "mark them at zero," while another said they would be "difficult to achieve." Even more alarming, we find evidence that Xylem failed to illustrate in its proxy statement revenue dis-synergies from current intercompany purchases of products from Xylem by Evoqua. In addition, Xylem's proxy statement represented that it could complete the transaction with cash on hand. Instead, it had to access short-term commercial paper and term loans to meet its obligations and total debt is $500 million more than expected. Xylem also filed an updated shelf registration after its first quarter completing the transaction, which suggests additional capital may be necessary.
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We believe investors should be alarmed that Evoqua was recently charged with revenue accounting fraud by the SEC and remains under federal investigation. We believe a federal indictment could significantly tarnish Xylem's reputation while potentially disrupting its operations. A former Xylem executive we interviewed who evaluated Evoqua when it came public called its financials "a maze" and "complex." While the period of SEC and federal investigation is from 2016 to 2018, Spruce Point finds additional areas where we believe regulators should expand their investigation. Notably, in January 2022, Evoqua completed its largest deal to acquire Mar Cor and structured a $12.3 million earnout, which it described as an "asset" recorded as an investment and to be held in escrow. A year later, with Mar Cor failing to achieve targets, the escrow amount was returned as a financing cash flow. We believe this allowed Evoqua to record nearly $5 million in cashless EBITDA benefits. In addition, in its last reporting period before the transaction closed, Evoqua reported a $15.8 million non-cash cloud computing-related intangible transaction without any explanation. We cannot find any other public company that has disclosed a similar transaction. Oddly, in the recent quarter of reporting after the close of Evoqua, Xylem reported a $16 million cash inflow labeled as software capital expenditures.
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We have concerns about recent governance changes in the period leading up to and post-closing of Evoqua. In May 2022, Xylem split its Audit and Finance Committees apart and Audit Chairman Jorge Gomez then resigned a little more than a year after his appointment. He was succeeded by Victoria Harker who had previously worked at WorldCom and specifically was CFO of its unit MCI Group (1998-2002). In 2003, the Report of Investigation by the Special Investigative Committee of the Board of WorldCom identified accounting concerns at MCI Group. Ms. Harker later led WorldCom's accounting restatement. At Xylem, Ms. Harker received the weakest support in the recent Director voting. In May 2022, Xylem's former Chief Accounting Officer departed, and shortly thereafter, Xylem received an SEC comment letter on August 1, 2022 that questioned various aspects of its financial reporting. These facts and circumstances are concerning considering the fact that Xylem recently released two sets of financial statements, and its reported $110 million minority cash investment in Idrica does not reconcile with the cash flow statement. Following the Evoqua deal announcement, Xylem CEO Patrick Decker entered into a 10b5-1 stock sale program. At the same time, management's annual short-term incentive targets were modified to ignore stock compensation and gains and losses on sold businesses. Given that 1) Xylem's share count increased by approximately one-third and 2) we see that Xylem has made past challenged acquisitions, we are concerned that management is no longer being held accountable for the dilutive aspect of the deal and may seek to dispose of struggling businesses it previously acquired.
- The bottom line is that an investment in Xylem presents a poor risk / reward for investors, given the Company's high expectations and its past failures from acquisitions. Sell-side analysts are moderately bullish on Xylem, yet there are no strong sell opinions on the stock. The most aggressive upside case assumes perfect deal execution and mid-single-digit revenue synergies, which we believe will fail to materialize. The average consensus implies approximately 13% upside to the share price, which is hardly attractive given investors can earn over 5% in risk-free alternatives while avoiding Xylem's execution risk and exposure to Evoqua's open federal investigation. Despite these overhangs, Xylem trades at a significant premium to a broad set of water industry and industrial peers. We estimate 30% ? 45% downside risk ($58.00 ? $74.00 per share) and expect Xylem to underperform the S&P 500 and water industry as its rich multiple compresses.
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Please note that the items summarized in this press release are expanded upon and supported with data, public filings and records, and images in Spruce Point's full report. As a reminder, our full report, along with its investment disclaimers, can be downloaded and viewed at www.SprucePointCap.com.
As disclosed, Spruce Point has a short position in Xylem Inc. and owns derivative securities that stand to net benefit if its share price falls.
About Spruce Point
Spruce Point Capital Management, LLC is a forensic fundamentally-oriented investment manager that focuses on short-selling, value and special situation investment opportunities. Spruce Point Capital Management, LLC is a member of the Financial Industry Regulatory Authority, CRD number 288248.
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